If you’re a small business owner or freelancer, estimated tax payments are a tough pill to swallow. This is especially true if you’re new to business ownership. Gone are the days when your employer withheld your taxes from your monthly paycheck. Now, you have to actually hand over money that’s already in the bank to Uncle Sam—a payout that can quickly erode cash flow.
Here are just some of the cash dilemmas business owners face when managing their estimated taxes:
Calculating What You Owe in Estimated Tax Payments
If your income varies from year-to-year or even quarter-to-quarter, it can be hard to predict what your estimated tax commitment is. Over-paying or under-paying can come back to bite you at tax time in the form of a penalty and a hefty tax bill.
Finding the Cash in the First Place
Paying a lump sum of cash to cover your income and self-employment taxes (Social Security and Medicare) isn’t always easy. If cash flow is already tight, that loss of cash can be problematic to even the most profitable businesses.
Leaving it Too Late
Estimated taxes are a pay-as-you-go tax, but if you choose to hold off quarterly payments and make your tax payment at the end of the tax year (in the hope your financial situation will turn around by then), the burden on your finances can be significant.
So what’s the best way to manage your estimated taxes, without eroding cash flow? None of this constitutes tax advice, but here are six recommendations based on my own experience of getting my arms around estimated tax payments:
1. Understand Tax Law and What It Means for Your Business
If your business has no employees or you’re a freelancer, paying estimated taxes is likely to be your biggest tax obligation. So spend some time with a tax advisor or CPA and learn what’s what. They may also be able to offer advice on how to manage your payments and calculate exactly what you owe. There are a number of methods for making that calculation. Learn more from the IRS.
2. Familiarize Yourself with the IRS Safe Harbor Rule
This is a good rule to know, because it can save you time and money. The Safe Harbor Rule helps estimated tax payers avoid the penalty and interest that they might incur if they don’t pay enough estimated taxes during the year. Here’s how it works:
If you pay at least as much as you paid the IRS last year or pay within 90 percent of your actual liability, there’s no penalty for underpayment. For example, if you earn more this year than last, you can still pay a quarter of last year’s taxes when you make each quarterly payment. Now, of course, you’ll have to even-up in April, so be sure to plan for that. There are exceptions to this, so again get advice from a tax pro on whether you can use the safe harbor.
3. Keep a Close Tab on Your Expenses
Expenses, woo hoo! Love them. These will offset your estimated tax payment nicely, so make sure you keep a record and deduct everything that you’re owed. If you use accounting software, many of these offer expense management mobile apps that sync your expenses as you go and keep track of everything in one place. If not, a good old spreadsheet will do the trick. Expenses you can deduct include travel and mileage, office supplies, software, training, business insurance, charitable donations, client gifts/entertainment, and much more. Check out the IRS guidance on business expenses.
4. Change Your Mindset
One of the first things you need to do when approaching your estimated tax payments is to plan ahead and separate your business and personal expenses. It’s very tempting to look at all the money that comes into your business as your own hard-earned income and forget that Uncle Sam wants a piece of the pie too. Get out of the mindset that all that income in your bank account is yours to spend or re-invest in your business. Which leads to my next point.
5. Plan Ahead and Set Aside Cash as You Go
Try to stick to the quarterly schedule of payments that the federal and state governments dictate. Put aside a portion of every client payment you receive (somewhere between 30–35% of each payment to be safe, although it can vary), preferably into a separate bank account. This makes it much easier to make your payments on time and in full (using cash that you’ve set aside) without worrying about your core cash flow.
6. Use Last Year’s Refund to Get Ahead
Another way to avoid a nasty cash shock is to use any refund gained from the previous tax year and apply it to you first estimated tax payment of the new tax year.
For the full lowdown on estimated taxes, check out this IRS guide.